What Is Financial Risk? Financial Risk Explained

The Oxford Dictionary defines risk as:

“A situation involving exposure to danger” and it goes on “The possibility that something unpleasant or unwelcome will happen.”

Thus we want to define what is dangerous and what is this unpleasant thing we want to avoid. 

A first obstacle stands in the way of determining risk. In fact, each of us seems to have a different perception of what danger is. 

For instance, you may be a firefighter that is so brave to jump into homes on fire and save people and still be very fearful when it comes to investing.

How do we take investing decisions?

Investing in corporate finance lingo means: 

Buying assets that earn a return greater than the minimum acceptable hurdle rate” (A. Damodaran).

Also, A. Damodaran used an interesting definition. He starts from the Chinese characters that express the word “crisis” and goes on to derive the two main aspects to consider when undertaking an investment decision:


As you can see the word “crisis” is comprised of two characters and each one has its meaning. In fact, the first means danger and the second opportunity. Thus, let’s start with this definition.

Each time an investment decision has to be taken, the investor faces the danger (which in finance lingo is called risk) to lose the capital invested (or not generating enough returns), while he also put himself in the condition to be highly rewarded (in finance this reward is called return) for the undertaken risk.

To simplify we have to find the % return that would convince the investor to risk his own money. To find this % return we have to study and understand what is risk and how to assess it.

What Is a financial risk?

The Oxford Dictionary defines risk as:

“A situation involving exposure to danger” and it goes on “The possibility that something unpleasant or unwelcome will happen.”

Thus we want to define what is dangerous and what is this unpleasant thing we want to avoid. 

A first obstacle stands in the way of defining risk. In fact, each of us seems to have a different perception of what danger is. 

For instance, you may be a firefighter that is so brave to jump into homes on fire and save people and still be very fearful when it comes to investing!

Also, in the investing world, there is a term used by behavioral economists, which is “loss aversion.” In short, it seems that we perceive losses way more than we perceive gains. 

This bias was first elaborated and verified by Amos Tversky and Daniel Kahneman. In other words, a 10$ gain is perceived more than twice less satisfactory of a loss of the same amount. 

This seems to be a built-in bias. Thus, we can do our best to define risk, although our definition may not be perfect.

Since risk is different according to the perspective of the investor, A. Damodaran proposes a useful approach, which is that of the “marginal investor.” 

In short, to define risk, you have to identify the marginal investor first. But who is this marginal investor?

Who is the marginal investor?

The marginal investor is the person or institution that at any time may hold the stocks of a company and therefore also influences its prices. 

The next step is to identify the marginal investor. How? Well, we have to look at the ownership structure of our target company. For instance, let’s look at who the marginal investors are for Apple:

As you can see from the image provided by Apple’s principal shareholders are Institutions and Mutual Funds. 

In fact, insiders hold just a tiny part of Apple’s issued shares. Thus, we can easily assume that Apple’s marginal investors are well diversified. 

That means that they will have a lower risk compared to a non-diversified investor. Why?

Let’s assume that you have all your capital invested in one company. What happens if that company goes bankrupt? You will lose all your wealth, wouldn’t you? 

Conversely, if you have your eggs in different baskets if one basket falls you will still have the other eggs; If you are an individual, you can diversify your financial risk by investing in various stocks or for instance in a stock index. 

What about businesses? How can a business diversify (thus reduce) its risk exposition? Let’s see the different components of risk.

Financial risk components 

There are five components of risk:

  • Project specific
  • Competitive
  • Industry
  • International
  • Market

If you are familiar with businesses, you may already know that they face several risks. For instance, although opening a restaurant always seems a good business idea, think for a second how many risks it faces.

First, if you want to run a successful restaurant you have to experiment new dishes continually. Now some dishes will work out some will not. 

Those that won’t work will also have a cost for you. We will call the risk of these dishes not working out project-specific risk. Second, you have to be better than the other dozens of restaurants in the neighborhood. 

To do so, you will cut prices, or improve the quality of the product and so on. You won’t know if this will work out for sure. Thus, we will call this danger competitive risk

Third, you have to be able to manage your budget, since the price of the ingredients for your recipes steadily increases. Also, you have to make sure the restaurant is always clean and that it is compliant with legal standards. 

Thus, you have to follow periodically any regulation changes that may be in the industry. And also, update your system to make sure the restaurant is run efficiently. 

All those things cost you money and can also endanger your business. Thus, we will call them industry risks. 

Fourth, if you opened a restaurant in another state, you want also to understand the regulations in that state. Assuming that the country also has a different currency, this will can affect your revenues either positively but also negatively. 

We will call this sort of danger international risk. And fifth, if an economic crisis strikes the restaurant will resent it. In fact, when economic conditions worsen people have less money to spend on their leisure activities. 

Thus, the revenues will considerably slow down. We are going to call this danger market risk. In conclusion, so far we identified five components of risk:

  • Project specific
  • Competitive
  • Industry
  • International
  • Market

The next question is “Until which extent can we get rid of risk?”

What financial risks can be managed? 

The primary objective of diversification is to reduce and manage risk. But the problem is that while some risk may be easily mitigated, others are not.

Perhaps, going back to the restaurant business, you may be able to diversify the project specific risk by trying out different dishes. For instance, you can play on the large numbers. 

If you try out ten new dishes, the chances are that nine out of ten will not work out. But the successful plate will generate more than enough revenues to cover the expenses incurred in trying out the other dishes plus an additional reward for the undertaken risk.

Also, if a successful restaurant just opened in your neighborhood, you could either compete with it or become an ally. How? Well, you may buy part of the ownership. 

This, in turn, will reduce the competitive risk. Huge corporations like Amazon, which bought Zappos, Facebook, which bought Instagram or Whatsapp and so on, use this same strategy. This is a way to diversify their business model

Now there is also the strategic reason for doing so. Perhaps, Zappos can make Amazon more valuable, but these deals are also driven by the necessity for these businesses to reduce the competitive risk.

Further, once the money from the restaurant business flows in you may want to consider investing it in other ventures as well. I did not say restaurants on purpose. 

In fact, if you keep investing in other restaurants, you may reduce your competitive risks, but this will not mitigate the industry risk. To diversify away this risk, you will invest in other industries. 

For instance, with the cash flow from the restaurant, you can buy a piece of real estate and rent it out.

Since you opened your restaurant in another state with a different currency and interest rates; Assume that you have a restaurant in San Diego, CA and you just opened another in Rosarito, Mexico. 

Although those restaurants are 50 minutes apart they are in different countries. In fact, in San Diego, you pay in dollars and Rosarito in pesos. 

A dollar is worth several pesos. Also, according to the World Bank Landing Rates U.S. has a 3.3% lending rate, while Mexico shows a 4.9%. 

Thus, you may want to borrow in U.S. dollars and finance the Mexico operations with that money, assuming they will accept dollars rather than pesos. In this way, you will diversify away part of your international risk!

A lot of hard work so far to take away some of the risk involved for being in business. Although you successfully managed to come so far, there is a form of risk that cannot be diversified. 

This is the market risk. In short, if the whole world economy will suffer (think of the 2008 global crisis), there is nothing you can do about it. As they say “A trouble shared is a trouble halved.” Hopefully, you saved enough money for the rainy days and will survive.

In conclusion, we analyzed the five components of risk and saw how they could be diversified away. Though, there is a component (market risk) that is not diversifiable. Let me summarize what we saw in this table below:

How do you Measure financial Risk?

So far we got two central concepts down, about risk. First, a risk is not an absolute concept but it somewhat depends on how well diversified is the marginal investor.

Also, we may argue that with new developments in behavioral economics we now know that there are also certain aspects related to risk (such as loss aversion and other built-in biases) that make risk an even more complicated topic. 

On the other hand, we are dealing with corporate finance; a world was shrewd financial managers assume that the marginal investors are rational. Thus, our second point is that marginal investors will tend to diversify their portfolios. Why?

Let me use an analogy here. I apologize in advance for using the Darwinian concept of evolution, but I believe it makes my point. In fact, natural selection works somewhere around these lines: nature has scarce resources (in most of the cases). 

Thus the individuals living in the same environment will tend to compete against each other for survival and reproduction. This will bring to the creation of strategies by each competing in the same situation. 

Eventually, nature will select the winning strategy and avoid the rest. In conclusion, these strategies will be passed on to progenies.

For instance, trees compete with each other for the sunlight. What is the best way to absorb sunlight? By being closer to the sun, thus by growing taller. 

For such reason, they tend to grow taller and taller until a forest will be created. While at the beginning of the process, you could see short trees, now they were utterly swept out. 

Thus, all the trees in the forest are tall, and they keep growing until they reach a limit to avoid losing their functionality (this is speculation). Eventually, all the trees in the forest will more or less have the same height. In short, there is a certain consistency.

If we go back to the financial world, we can use the same example. When all the marginal investors understand that the strategy to manage the risk is to diversify the portfolio, they all start to use diversification. 

On the other hand, there is a point in which the marginal benefit of diversifying will be null. In fact, as we saw there is a component of risk (market risk or systematic risk) that cannot be diversified. 

Consequently, if you hold ten stocks or one hundred, it does not make any difference. Instead, it just increases the cost associated with managing such a portfolio. 

In conclusion, all the marginal investors will hold diversified portfolios, which will carry only systematic risk. Thus, this means that wherever we look in the markets, we will find diversified investors. 

Conclusively, the simplest way to compute the risk of a security is to assess the systematic risk or that part of the risk that cannot be diversified away.

What Are The Different Types of Financial Risk?

As we saw, financial risk is an inevitable part of personal and business finance.

It is important to understand the different types of financial risk in order to make informed decisions when it comes to your finances.

Let’s see in detail all the types of financial risks to take into account.

Market Risk 

Market risk is the risk of investments losing value due to changes in the overall market.

Examples of market risk include volatility of stocks and bonds, and currency fluctuations.

Volatility of stocks and bonds means that the prices of these investments can fluctuate significantly due to changes in the market, which can lead to losses for investors.

Currency fluctuations occur when the value of a currency changes due to changes in the market, which can also lead to losses for investors.

Credit Risk 

Credit risk is the risk of a borrower or issuer of a financial instrument defaulting on their obligations, or filing for bankruptcy.

Defaulting on loans can occur if a borrower is unable to repay the loan, while bankruptcy occurs when a borrower is unable to repay their debts.

Operational Risk 

Operational risk is the risk of losses due to human error, inefficient processes, or inadequate systems.

Human error can occur if an employee makes a mistake when processing a financial transaction, while inefficient processes can lead to errors and delays in processing transactions.

Inadequate systems can also lead to errors and delays in processing transactions.

Liquidity Risk 

Liquidity risk is the risk of an investor being unable to sell their assets quickly in order to meet their financial obligations.

Examples of liquidity risk include difficulty selling assets and cash flow issues.

Difficulty selling assets can occur if the market is illiquid, or if there are few buyers for a particular asset.

Cash flow issues can occur if an investor does not have enough cash to meet their obligations.

Systemic Risk 

Systemic risk is the risk of losses due to fluctuations in market conditions or contagion risk.

Fluctuations in market conditions can occur if there are changes in the overall market, which can lead to losses for investors.

Contagion risk occurs when a default in one sector of the market leads to losses in other sectors of the market.

Political Risk 

Political risk is the risk of losses due to changes in tax laws or regulatory requirements.

Changes in tax laws can affect the amount of taxes an investor must pay, while changes in regulatory requirements can affect the ability of an investor to conduct certain activities.

Interest Rate Risk 

Interest rate risk is the risk of losses due to rising or falling interest rates.

Rising interest rates can lead to increased borrowing costs, while falling interest rates can lead to decreased returns on investments.

Inflation Risk 

Inflation risk is the risk of losses due to rising prices or decreasing purchasing power.

Rising prices can lead to increased costs for goods and services, while decreasing purchasing power can lead to decreased returns on investments.

Why is it Important to Manage Financial Risk?

Managing financial risk is essential in order to maintain a healthy financial position.

In order to do so, companies must identify and assess their financial risks, develop strategies to mitigate them, and monitor their performance.

Companies should consider using a variety of risk management tools such as hedging, diversification, and insurance to help manage their financial risks.

Proper risk management can help companies to protect their investments, maximize profits, and achieve their long-term business goals.

Connected Financial Concepts

Circle of Competence

The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 


Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.


Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio



The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

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